Retire More Quickly and Richly with an HSA
What's an HSA?
HSA stands for Health Savings Account. It is a tax-advantaged savings account from which one can pay medical expenses.
Oh, I think I've got one of those. I'm always scrambling in December to empty it so that I don't lose it, right?
No, I think you're referring to a Flexible Spending Account (FSA). An HSA is not an FSA. Although both are used to pay medical expenses in a tax-advantage manner, HSAs are not subject to annual "use it or lose it" rules. In fact, you can wait decades before reimbursing yourself from your HSA for a medical expense incurred today. Also, funds inside an HSA can be invested until they are needed.
Why should I care?
If you are eligible, an HSA can be an amazingly tax efficient retirement savings vehicle.
Am I eligible to open an HSA?
If you are enrolled in a high-deductible health plan (HDHP), yes.
I do have an HDHP. How do I open up an HSA?
There are several good HSA administrators out there, but we are especially fond of Lively. AlphaGlider can manage investments in a Lively HSA for you.
Few people know about the Health Savings Account (HSA), which is a shame because it is one of the most attractive retirement savings vehicles available to those who qualify. It has the best attributes of a traditional pre-tax individual retirement account (IRA) — tax deductible contributions, and no tax on interest, dividends, and realized capital gains on investments while they are held in the HSA. And it has the best attributes of a Roth IRA — no taxes when qualified distributions are made. Play by the rules and you'll never be taxed on earned income you divert into an HSA — not in the present on the earnings you contribute to the HSA, not over the decades you hold investments in your HSA, and not when you ultimately take a qualified distribution from the HSA. There are few activities that avoid the long arm of the IRS, but the HSA is one of them.
So just how efficient is the HSA as a retirement vehicle? Extremely efficient.
Below is a chart that summarizes the after-tax value of three retirement vehicles (HSA, IRA, and taxable account) available to a typical AlphaGlider client — a double-income Colorado couple, both 40 years old, with a combined income of $250,000 and enrolled in a high-deductible health plan (HDHP). The orange HSA line shows the balance of their HSA if they maxed out annual contributions until they retire in 25 years at age 65. The green and blue lines show what the couple would get in after-tax funds if they instead directed their annual HSA contributions to either an IRA or a taxable account, respectively. See the key assumptions I make below the chart.
Source: AlphaGlider
Key Assumptions: Colorado family with adjusted gross income of $250k/yr; max out allowable HSA contributions for 26 years (2% annual growth) with equivalent pre-tax contributions to the IRA and to the taxable account; annual pre-tax portfolio returns of 6.0% (2.5% from dividends, 3.5% from price growth); 20% annual portfolio turnover; marginal tax rates of 32% federal and 4.63% state, 15% federal capital gains tax rate, 33% portfolio qualified dividend income (QDI)
With no additional cost, the couple would $161,000 better off entering retirement by contributing to an HSA over the next 25 years relative to contributing to an IRA (under my assumptions, Roth and traditional IRAs perform equally well because I assume their marginal tax rates do not change in retirement). And compared to funding a taxable account, the HSA will provide the couple with an additional $208,000. Said another way, the HSA generates the full 6.0% annual return of the assumed portfolio, whereas the IRA has a 4.1% after-tax annual return, and the taxable account has a 3.2% after-tax annual return. As this exercise demonstrates, taxes can be a major drag on investment returns. For the Roth IRA, the tax hit is on the earned income used to fund the contribution. The taxable account also suffers from this tax, in addition to taxes on interest, dividends, and realized capital gains. On the other hand, the traditional IRA shelters earned income from taxes, but is ultimately hit with income taxes on distributions. The HSA dodges all of these taxes — unless you happen to reside in California or New Jersey. The state tax authorities of these two states treat HSAs as normal taxable accounts, thus there is no break on state taxes on HSA contributions, interest, dividends, and realized capital gains. Still, HSAs are superior retirement savings vehicles relative to taxable accounts and IRAs for Californians and New Jerseyans due to the shelter from federal taxes that they provide. If our Colorado family moved to California where they would face a 9.3% marginal state tax rate, their HSA would still generate $115,000 more than an IRA, and $166,000 more than a taxable account, upon reaching retirement age.
HSA INs & OUTs
In order to open and fund an HSA, you must be enrolled in a high-deductible health plan (HDHP) and not yet enrolled in Medicare (first eligible at age 65). In 2019, the IRS defined an HDHP as a health insurance plan with annual minimum deductibles of $1,350 for individuals and $2,700 for families, where the insured pays the first costs of healthcare up to the deductible before any insurance payments kick in (including prescriptions but excluding preventative care). An HDHP must also have annual out-of pocket maximums that are at, or below, $6,750 for individuals and $13,500 for families. These dollar figures are indexed to inflation, so they will change from year to year. Most insurance companies indicate if their plan is an HDHP by including "HDHP" or "HSA" in the plan title, as Anthem has done below.
Source: Connect for Health Colorado
Sorry if your company-provided health plan is too generous to qualify as an HDHP, but it's actually a good problem to have. I don't need to tell you that health care is incredibly expensive here in the US, so no complaints if your employer is picking up most of the tab for a low-deductible plan. But if your employer does give you a choice of health plans, or you are self-employed and thus forced to buy your plan from a health insurance marketplace, you may find that an HDHP is the lowest all-in cost option because of the generous tax benefits provided by the HSA you can fund.
Although an HDHP is required to open and fund an HSA, both are administered independently by separate companies. Once you are in an HDHP, you will need to open an HSA with an HSA administrator. We're partial to Lively, but here is a good HSA review website to get you familiar with some of your better options: The HSA Report Card. If you want to use your HSA as an investment vehicle as I recommend, then you will need to request an investment account while applying for the HSA. Most HSA administrators outsource the custody of HSA investments to outside custodians — for example, Lively uses TD Ameritrade to custody their HSA investment accounts.
The IRS caps annual HSA contributions at $3,500 for individuals and $7,000 for families in 2019, figures that are indexed to inflation. Additionally, if you or your spouse are 55 and over, you are each allowed an additional $1,000 "catch-up" contribution. For example, a couple in their late 50s is able to contribute $9,000 to their HSA this year, $7,000 for their familiy allowance, and $2,000 in catch-up contributions as they are both over 54 years of age.
You will want to file away your qualified medical expense receipts that you pay out of pocket just in case you get audited during a year in which you make an HSA distribution. There is no deadline for when you have to reimburse yourself tax-free for eligible expenses from your HSA, so you can reimburse yourself for these expense many decades from now. To make sure that I don't lose my family's medical receipts, I scan them to a cloud-base drive which is also backed-up, and then I enter some basic receipt details into a spreadsheet to give me a running track of my reimbursable qualified medical expenses. Although an HSA is individually-owned, it can be also tapped to reimburse qualified medical expenses for one's spouse and/or dependents. And even if you no longer have an HDHP but still maintain an HSA with a positive balance, future qualified medical expenses can be reimbursed with your HSA. Note that medical expenses that you deduct on your taxes, or pay with a flexible spending account (FSA), can't also be reimbursed with your HSA. No double dipping.
Like a Roth IRA, there are no required minimum distributions (RMDs) from an HSA. And like all IRAs, an owner's spouse inherits the HSA without tax implications. However, the tax treatment for non-spousal HSA beneficiaries is quite a bit worse than it is for IRAs — the HSA ends on the date of death and the fair market value becomes taxable income to the beneficiary. However, the beneficiary can pay off the deceased's unpaid medical bills within a year of the death. I recommend that unmarried owners of HSAs begin drawing down their HSAs in their 70s for this reason.
Given the high price of healthcare in the US, I suspect most HSA owners will accrue enough qualified medical expenses before and during retirement to fully liquidate their HSA. But if this isn't the case, non-qualified distributions after turning 65 (or if disabled) are treated just like that of a traditional IRA distribution — taxed as income. Only non-qualified distributions taken before age 65 are penalized with a 20% surcharge, in addition to also being taxed as income. Below is a helpful graphic that you can use to determine the tax treatment of your HSA distribution.
Source: Haylor, Freyer & Coon, Inc.
The AlphaGlider HSA
Starting today, AlphaGlider is pleased to announced that we can manage HSAs for our clients. Open up an HSA at Lively, tell Lively that you want an investment account at TD Ameritrade, fund it (or transfer over an existing HSA from another custodian), give permission to AlphaGlider to trade it, and we'll take it from there. Given its favorable tax status, your HSA will play an integral role minimizing the impact of taxes on your portfolio returns via tax sensitive asset location. Lively doesn't charge administration fees like most HSA administrators, and like with your other investment accounts at TD Ameritrade, most of your trades are commission-fee. You'll be able to track your HSA on the user-friendly websites and mobile apps of Lively, TD Ameritrade, and AlphaGlider. When it comes time to make a distribution, just let us know when and how much and we'll make the liquidation trades for you.
Looking for more information about HSAs? I recommend that you check out Lively's website and IRS Publication 969. If you have any questions about your particular situation, please reach out to me at the contact details listed in the webpage footer, or post your questions in the "comments" box below.